Small caps may be ready to outshine large caps

Investors have shunned small cap stocks like the plague but the tide may be turning. “They are unloved, people are under-allocated to them, they over-allocated to large,” notes Jim Paulsen, Chief Investment Strategist, Wells Capital Management.

The Russell 2000 (^RUT) returned just 3.8% in 2014 trailing the 12% gain of the S&P 500 (^GSPC). As a result, small-cap fund flows trailed large-caps by the largest margin since 2000, estimates Paulsen, which is a positive sign for small stocks. “There is a lot of money that could swing their way if things improve.”

For Paulsen, disinflation is the key to that improvement. “Worst thing for small caps is a disinflationary environment.” Smaller companies have fewer options to cut costs and tighten margins. Large corporations typically have more fat to work with.

Disinflation may get some assistance from quantitative easing programs underway in Europe and Japan. “Everyone is working so hard to defeat deflation, I think we are going to get a little reinflation back and that really favors small cap stocks.”predicts Paulsen.

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If that happens, smaller companies may see a boost in corporate profits. “If top-line pricing becomes a little better, then you’ve got greater operating leverage in small companies and that means greater earnings leverage.” says Paulsen.

There are signs an early turn may be underway, so far this year, the SPDR MidCap 400 ETF (MDY) has advanced nearly 4% and the Russell 2000 over 2%.The S&P 500 has gained over 1%.

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